May 23, 2014

Another Look at Thomas Piketty’s ‘Law of Inequality’

Utilizing massive historical documentation, Thomas Piketty argues that as returns to invested capital outstrip the rate of economic growth, income from wealth grows faster than the economy – concentrating more and more money and power in the hands of a few. As these returns are reinvested, inherited wealth will grow faster – concentrating even more money in fewer hands. When incomes from capital become more concentrated than incomes from labor – e.g., today, the wealthiest 10% earn almost the same amount of income as the rest of the country – personal income distribution will also become more unequal. So far, this is not an earth-shaking economic revelation.

No one can deny the fact that those at the bottom and increasingly those in the middle are doing poorly while those in the top 10% are grabbing an increasing fraction of our nation’s income (see: TABLES 1,2).

SOURCE: Piketty and Saez : 2003 data updated to 2012.

Computations based on family market income including realized capital gains (before individual taxes). Incomes exclude government transfers (such as unemployment compensation and social security) and non-taxable fringe benefits. Incomes are inflation-adjusted using the Consumer Price Index.

The 4th column shows the fraction of total real family income (loss) captured by the Top 1%. For example, from 1993 to 2012, average family income grew by 17.9%, but 68% of that growth went to the Top 1% while only 32% went to the Bottom 99%. During the 2009-2012 recovery, income concentration for the Top 1% returned to its huge pre-recession level and then some. Average family income grew only 6%, but 95% of that growth was grabbed by the Top 1% while practically zero went to the Bottom 99%. The Top 1% have about fully recovered from their loss during the 2007-2009 Great Recession, but the Bottom 99% are still sitting with their loss.

In my view, Piketty’s major innovative breakthrough in economic thinking is that the forces at play creating an obscene outsized societal income and wealth inequality – as has been occurring in the U.S. for past 30 plus years – self-reinforce and self-perpetuate inequality to new levels, fostering societal stratification and instability in which people are not moving forward together. Ordinary people are being more and more separated from those with economic and political power.

Unless these forces are reined in and income/wealth distribution becomes fairly balanced as was the case for 30 years after WWII, concentrated asset wealth will continue to benefit the rich and debt will continue to overwhelm the middle class and poor as the latter spend beyond their means to keep up. An economy like the U.S. – that is so dependent on 70% consumption, very low savings (vs. 58% consumption in Europe and 10-12% savings), stagnant wages, and maxing-out credit card debt to achieve a reasonable GDP growth – inevitably ends up reducing both consumer expenditures and economic growth and increasing personal debt levels - driving the next Great Recession where the rich will again come out on top.

Part of the self-perpetuating enriching process of the few stems from a political system that is poisoned and warped by the influence of big money – a system giving inordinate power to those at the top. And the warping process is getting worse as the wealth of the top 10% grows larger. Those at the top take advantage of their market and political power not only to limit redistribution but also to shape the rules in their favor in order to increase their own income and wealth at the expense of the rest.

Let’s be clear: this paper is not about arguing for a system of equality of income and wealth, a favorite line of dogmatic conservatives. It’s about recovering a system we once had of equality of opportunity, a decent wage and fair play i.e. a rising economic tide that brings the standard-of-living of all citizens “commensurably” forward … precisely the opposite of what one sees happening in TABLES 1 and 2. During the 2009-12 recession recovery, the wealthiest 1% captured 95% of income growth, while the bottom 90% became poorer.

SOURCES: The World Top Incomes Data Base; The Washington Post; Sloan School of Management; U.S. Treasury Department; U.S. Census Bureau; Piketty and Saez, etc.

If the above doesn’t confirm a process that is phasing out the middle class, what does? Most Americans have seen their incomes sink or stagnate while incomes of the top 1%, 5% and 10% have come about at the expense of those below. The median income (adjusted for inflation) even for households of individuals with a bachelor’s degree or higher fell by a tenth from 2000 to 2010. (see: http://www.census.gov/hhes/www/income/data/historical/household/ ) .

U.S. family members are working up to 60 hours a week and using credit card debt to maintain their standard of living. The average real minimum wage of $10.69 has steadily declined from 54% of average real hourly earnings of $19.85 in 1968 to 36% of real average hourly earnings of $20.31 today based on a real minimum wage of $7.25 in 2013. (Source: Congressional Research Service, “Inflation and the Real Minimum Wage,” Jan. 8, 2014). Shockingly, the U.S. average CEO salary has exploded exponentially from 44 times the average worker salary in 1974 to over 300 times, in 2013. In sharp contrast, the EU average CEO salary has been relatively stable at 44 times the average worker salary in 1974 to 50 times today.

The wealthy lost some of their wealth in the Great Recession as stock prices declined, but the 1% wealthiest now hold 240 times the wealth of the typical American – twice the ratio in 1962 and 1983 when the numbers were already sky-high at, 125 to 1 and 131 to 1, respectively. A hollowing-out of 80% of working Americans is in process where mobility upward has been at a standstill, with nearly rock bottom wages, few benefits, and labor rights.

Piketty’s main thesis is about pure capitalism’s inevitable, automatic creation of an ever expanding income and wealth concentration for the few and relative stagnation of incomes and wealth for the rest. His thesis revolves around what is termed “The first fundamental law of capitalism,” which incorporates Piketty’s following economic values for determining inequality:

(a) = the share of capital incomes in national income

(r) = the rate of return, in real terms, on capital

(g) = the rate of growth of the economy

(B) = the ratio between capital income and national income

Piketty’s historical studies show that the (B) ratio was a very high 7 in the UK and France, 6 in Japan, and 5 for the U.S. prior to WW I. During the next 50 years through 1975, the (B) ratio dropped precipitously to about 3.5 in the UK and Europe and to below 4 in the U.S., the latter helped by much higher marginal tax rates, a labor-friendly atmosphere, higher inheritance taxes, etc., causing a far more equitable personal income and wealth distribution. In the last 35 years, the (B) ratio has soared back to levels corresponding to those before WWI.

The first fundamental law of capitalism says that the share of capital incomes in national income, (a), is equal to the rate of return on capital, (r), times the ratio between capital income and national income (B). Concerning this law, Piketty’s brilliant finding is that when the rate of return on capital (r) is permanently above the rate of growth of the economy, (g), then the share of capital in national incomes, (a), increases. This, in combination with an increasing ratio between capital income and national income, (B), will drive the share of capital in national income to new high peaks thereby also intensifying income and wealth inequality to a more dangerous level.

Just as climate change from accelerating CO2 emissions is intensified by positive feedbacks, so is wealth concentration intensified by a positive feedback. Piketty clarifies this feedback in simple language. As capital’s share in national income increases, capital owners become wealthier. Assuming they do not consume the entire return on their capital, they will have savings to reinvest to further increase their wealth share. This is in sharp contrast to the bottom 90% of the working population which has most of its capital tied up in homes and some in stocks, bonds or small proprietorship businesses. Their small annual capital gains are mainly used to maintain personal living standards.

In a recent interview, Piketty illustrated what one person called his “First law of inequality,” and its inevitability under capitalism with the following example:

“Imagine a hypothetical village from centuries ago where neither the population nor the economy was growing. …. Even in a zero-growth society, however, assets that helped people to produce goods – also known as “capital” – had value. In our hypothetical village, a large farm might produce $10,000 worth of crops in a year, yielding $1,000 in profit for its owner. A small farm might have the same 10% rate of return on $1,000 in annual crop sales, yielding $100 in profit. If the large farmer and small farmer each spent all their money every year, the situation could continue ad infinitum, and the rate of inequality in the village would NOT change.

But one of capital’s greatest advantages is that its owners can make enough income to spend some of their money, save and eventually reinvest the rest. If the large farmer saved $500 of that $1,000 profit, he could buy more capital assets, which would bring in more profit. Perhaps a few owners of small farms had small debts to pay, and one of the large farmers bought them out. Eventually, the owner of the expanding farm might find himself owning land that yielded $1,500 or $2,000 in annual profit, allowing him to put aside more and more for future capital acquisitions. Less stylized versions of this story have been playing out for centuries.”

As the interviewer noted, “The fact that the rich earn enough money to save money allows them to make investments (many times at low capital gains tax rates) that other people cannot afford. And the investments often bring in a positive return on capital generally higher than the rate of economic growth.” This capitalistic process efficiently creates income and wealth inequality. Piketty describes this relationship, when the rate of return on capital exceeds the rate of growth of the economy, as (r) exceeds (g).

Will (r) Always Exceed (g)?

Piketty cynically thinks the marginal return to capital will not decline. In his opinion, global competition for capital and the financial sophistication to find new, productive uses for capital will all help to keep the return on capital (r) at a higher level than (g). Unless this is checked by appropriate taxation and by aggressive establishment of worker-owned enterprises, including public banks and credit unions for start-up and expanding small businesses, then a continuing high (r) spells Big problems ahead for the economy, for quality-of-life and societal stability.

Right now, despite slower job growth, Europe’s advanced economies are far better balanced in the functional, fair distribution of income and wealth as well as recycling of national income for social well-being. Here, tax rates progress substantially for personal taxable incomes in the highest tax bracket. The Netherlands is a typical example of this. The maximum Dutch tax rate for incomes above $80,000 (Euro 55,991) is 52% compared to a U.S. maximum tax rate of 39.6% on income above $425,000 for a head of household. The Dutch tax rate on savings and investments is 30% compared to a far lower U.S. capital gains tax rates. Further, U.S. Top 1%, 5% and 10% income earners can divert much income into relatively low capital gains with tax rates varying from 0% for those in the 10% to 15% brackets up to 20% for those in the highest 39.6% tax bracket. This has helped accelerate U.S. wealth concentration to the highest levels in the world for top 10% income earners – with the possible exception of Saudi Arabia or Dubai.

A U.S. societal transformation to shared ownership and public banking will help diversify rather than concentrate wealth. Such an approach roots the incomes and wealth it generates back to communities and regions – as opposed to transferring profits, assets and resources away from Main Street communities to Wall Street’s multinational corporations and their global shareholders.

As the IMF has stated recently, “Policies that reduce inequality have a more benign effect on growth than once thought.” In fact, they will spur growth by putting more money in middle class pockets to save and consume without relying so heavily on debt to maintain a decent living standard.

“The issue is not how we shall make everyone equal. We can’t do that, though we can hand tyrannical power over to those who promise to do it for us. The question is how we can establish and maintain a decent social structure that ties, however loosely, the garnering of great wealth to the promotion of the general welfare while limiting evil conduct in the pursuit and use of wealth …. As Aristotle recognized, more than 2,000 years ago, a successful polity must have a strong middle class. People who have a substantial stake in the economy while still having to work within it are necessary for that economy’s stability. Such folk also are necessary for political and social stability because they thrive, not on “creative destruction” (which is, after all destructive) but rather on hard work (editor: fairly compensated for value contributed) aimed at steady, intergenerational improvements.”